ECB acts to head off deflation risk

Following on from the press conference held yesterday, Azad Zangana, European Economist at Schroders, gives his view on the interest rate cut and the non-conventional measures announced

"European Central Bank (ECB) president Mario Draghi has announced interest rate cuts along with a whole host of non-conventional measures to head off the rising risk of deflation in the Eurozone. The ECB has cut the main policy interest rate (refinancing rate) from 0.25% to just 0.15%, but in addition, has lowered the deposit rate to -0.10%, meaning that banks will now have to pay the ECB for holding deposits at the central bank instead of receiving interest as is normally the case. In addition to the cut in interest rates, the ECB announced three further policy measures:

"First, two 4-year targeted long-term refinancing operations (TLTROs) at lower costs to banks than in the past, but limited to an initial €400 billion. The TLTROs will be followed up with additional lending, but the amount available for those future loans will be three times the size of the net new lending conducted by banks in the intermittent period. This is similar to the UK's Funding for Lending Scheme, where the provision of new funding is dependent on how much the banks had previously lent out.

"Second, the ECB will suspend the sterilisation of the Securities and Markets Programme (SMP – previous bond buying programme). This should add approximately €160 billion of liquidity in short-term money markets.

"Finally the ECB announced it will intensify efforts to begin outright purchases in asset backed securities (ABS), but stopped short of announcing dates or amounts.

"Overall, the policy measures announced today are helpful but do not significantly change the outlook for growth or inflation in the near future. In terms of our forecast, we had expected a slightly larger cut in interest rates, but the additional measures present some upside risks. The extent of those risks depend on whether bank lending significantly improves and whether the Euro can see a reasonable depreciation (has not been the case so far).

"As Draghi said in his press conference, the ECB cannot force banks to increase lending nor lower interest rates to households and corporates. With regards to the measures announced, we disagree with the move to take the deposit rate into negative territory as this raises the funding costs for banks, which will either increase charges on savers or increase interest rates on borrowers. However, the move to provide new targeted-LTROs will help to offset those costs, but only for those banks that choose to be involved in the stimulus programme. Given the vast majority of banks can now freely access funding from financial markets, the take up is likely to be lower than expected. Moreover, the initial €400 billion target announced (clearly to appease the German Constitutional Court) is too low in our view and should be raised to at least a trillion euros. The halting of the ECB's SMP sterilisation would in theory lower money market rates, but given they are at near zero, the move will achieve very little for the real economy.

"Finally, the buying of ABS could be very helpful in boosting loans to the real economy. However the absence of liquid transparent markets makes the ECB vulnerable to moral hazard. A commitment to this form of quantitative easing is welcomed. We expect this policy to begin around the end of the year if the ECB still feels it is required. It is likely to begin in very small quantities, but has the potential to provide a boost.

"More importantly, today's action shows that the ECB is aware of the rising risk of deflation, and is prepared to act in a targeted manor."